Back in the early 1990s when I was working for A. G. Edwards, a national full-service investment firm, a mutual fund representative gave all of us in the office a t-shirt promoting a new fund. The new stock mutual fund he was touting intentionally held less than 30 or so stocks, with the idea that the portfolio manager’s best 30 stock picks would fare better than her best 100 stock picks. On the t-shirt was the name of the mutual fund with a quote from investor guru Warren Buffett that stated “Wide Diversification Is Only Required When Investors Do Not Understand What They Are Doing”. Later on about a dozen of us from the office decided to all go bowling together and wear our incredibly brilliant t-shirts. Decades later, I now understand how ridiculous we must have looked. After we bowled a few games, it was also obvious that our bowling skills were on par with our embarrassing investment advice plastered on our backs. Please forgive me- remember it was the 90’s when the stock market pretty much only went one direction: up.
I will stay with diversification, in spite of the advice from the clever billionaire. Modern portfolio theory (MPT) defines risk as the standard deviation of return. Simply put, the lower the standard deviation of a portfolio (or individual stock, mutual fund, ETF, etc), the less an investment deviates from its average. We also call this “volatility”. To a degree, increasing the number of stocks you hold in your portfolio can reduce this volatility. Another measure, correlation, determines how two variables (stocks in this case) are related. The correlation coefficient, which can vary between -1 to +1, indicates the interdependence between two stocks, with -1 meaning the stocks are perfectly negatively correlated and move in opposition directions to each other, to +1 which means the two stocks move perfectly in the same direction. By holding different asset classes in your portfolio, such as domestic bonds, domestic stocks, international bonds, international stocks, large cap, mid-cap, small cap stocks, REITs, and gold one can theoretically maximize return and minimize risk. Physicians often own other investments other than marketable securities that are less liquid but also are a great way to throw some negative correlation or zero correlation investments into their total portfolio mix. These include real estate assets such as apartment buildings, rental property, office property (including their own clinics, surgery centers, medical space – beware of Stark!), collector antique cars, coin collections, and many others. Financial planners are typically big fans of asset allocation and diversification because of these factors. MPT is not perfect, but it is certainly worth paying attention to.
Diversification of your investment assets however is only one way a physician should practice risk management with their investments. Other risks abound that could torpedo your retirement plans and your future well-being. Here are three more ways to diversify your investments:
Investments that are tax deferred such as your 401(k), 457, and IRA rollover accounts (in which you receive a tax deduction when you contribute, but are taxed when you withdraw) will be taxed differently in retirement than your Roth IRA accounts (in which you get no deduction when you contribute but pay no taxes when you withdraw). Since January 1, 2010, there has been no income limitation to individuals that would like to convert their existing IRA accounts to Roth IRA accounts, which has allowed higher earners such as physicians to convert their IRAs to Roth IRAs. This strategy is essentially paying the tax on the seed today (the current IRA account now) and reaping the rewards of the harvest (the future hopefully much larger Roth IRA account) in retirement tax-free. However, it may not be wise to convert all your IRA accounts to Roths, any more than it may not be wise to have all your retirement assets in an IRA or 401k that will be taxed fully upon retirement. What if Congress in the future changes the tax benefits of a Roth, and you had spent a king’s ransom in taxes when you converted? What if your tax rate in retirement (a key variable in determining the benefit of a Roth IRA conversion) turns out to be much lower or higher than you thought? Having a tax-diversified strategy by saving for retirement using both types of accounts may be wise.
Investment Style Diversification
The battle is still undecided: Passive Investing vs. Active Investing. I have read research papers and listened ad nauseam to evidence from both sides of the argument since I first gazed on the wonders of Modern Portfolio Theory in business school in 1985. In a nutshell, some believe that using low cost index funds (Passive) is a smarter way to invest, while others believe that rebalancing a percentage of your portfolio into assets in various categories in order to take advantage of favorable market pricing or attractive market sectors (Tactical or Active Investing) is smarter. There is much to be said on this topic, but rather than draw the line and place all of your investments into one of the two strategies, why not consider a mix? Once I determine a client’s risk aptitude, we offer passive low cost portfolios using exchange traded index funds (ETFs), as well as offering mutual fund portfolios and tactical portfolios I manage. We often will have a client with multiple accounts use a different strategy with each account. If you have a large account, you may want to consider breaking it into to two accounts and using different investment strategies.
Cash Flow Diversification
In retirement, you will structure typically a number of methods to provide yourself income. Some include tax-deferred accounts such as a pension, IRA/Roth IRA systematic withdrawals, 401k /457/ 403(B) plans, as well as Social Security and withdrawals from your taxable investment accounts and saving accounts. When developing a financial plan for a client, it really comes down to two different cash inflows that a client will have: fixed and variable. The fixed accounts, such as pensions, social security, and fixed annuities, are easy to project on the financial plan since there is little or no guesswork involved on what the cash flow will be. The variable accounts, such as the IRA and 401k plans, are just that….v-a-r-i-a-b-l-e ! Tell me what your investment performance on your IRA Rollover account will be for the 30 years that you are in retirement and I can tell you what the cash inflows will be. Often if a physician is offered a pension as part of a retirement benefit, the doctor may have the option to forgo the fixed pension and take a “lump sum” and roll that to a self-directed IRA or investment advisor to manage. A calculation can be done to determine which option may be the best. Many variables go into the lump sum or keep pension calculation, but the point is maybe having all your income source at retirement in one method is not wise. Having all pension income (company pension and a social security check) is usually very predictable and usually considered conservative. You also cannot outlive pension income, but few private pension plans have a cost of living index adjustment, so your standard of living can be reduced in retirement. An individual that retired in 1990 with a monthly pension of $3,000 would now need $5,190 to purchase the same goods. That 73% increase in living costs over 22 years will certainly reduce the person’s lifestyle. Alternatively, having all your retirement funds in an IRA rollover account at retirement could spawn problems as well. Poor account performance and the reality that the account can actually deplete to $0 have some stark consequences as well. Why not, if you have the capability, consider both sources of cash inflows in retirement?
Like the tacky t-shirt that I wore a couple decades ago stated, if we knew what the future holds we would not need to diversify. Some may be so bold as to proclaim they have all the answers thanks to their personal crystal ball. Sorry, but I am not one of them. I do understand risk management however, and think diversification in all forms can be a great financial planning technique!